Opinion: Janet Yellen could be your new financial adviser

JohnCoumarianos

It’s ironic when a financial adviser says “Don’t fight the Fed.” After all, if investors are supposed to take investment advice from the Federal Reserve, then why do they need an adviser?

But that’s exactly what Charles Lieberman has done in a recent Bloomberg article arguing that stocks aren’t expensive now because low interest rates justify higher prices. Lieberman is defending the “Fed Model,” which compares the earnings yield (the inverse of the P/E ratio or E/P) of stocks to bond yields or, more specifically, the 10-year Treasury bond
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That means if bond yields go down — or, really, if the Fed pushes them down — then E/P should go down too. And since “E,” or earnings, don’t move so quickly, that means “P,” or the price of stocks, should go up.

Another financial adviser and pundit, Barry Ritholtz, calls Lieberman’s argument “nuanced” for not latching on to a valuation number and applying it to all markets across history. What appears like overvaluation in a different environment isn’t overvaluation now, with rates so low.

There is some truth to the Fed Model in the sense that it describes what is often seen in practice — at least over the last half century or so. As the Fed lowers interest rates to make government and high quality corporate bonds unappealing, investors, in response, pay higher and higher prices for junk bonds, REITs, other common stocks, subprime mortgage-backed bonds — whatever it may be — and push yields from those instruments down. And, after all, this investor movement from low-risk to high-risk assets is partly what the Fed wants when it lowers rates.

REITs, for example, tend to yield one percentage point over the 10-year Treasury, on average, so, when bond yields drop, we’ve seen REIT prices move up until their lower yields settle roughly at one percentage point higher than that on the 10-year Treasury. The same thing happens with junk bonds, which have traded so that they yield roughly five or six percentage points more than Treasuries. But it’s true for the overall stock market too.

Unfortunately, observing a phenomenon doesn’t always tell us how to invest, which entails some estimation of future returns. Clifford Asness of AQR Management has noted in a paper, “Consider the small investor who might hear pundits say stocks are fair or cheap, according to faulty Fed model logic. It seems reasonable that this investor might take this to mean the stock market’s long-term prospective real return is favorable when compared to historical returns.”

But Asness shows that long-term future stock returns are still correlated to the starting Shiller PE ratio (current price relative to past 10-yr average earnings). Stock returns are a function of starting P/E and the future real earnings per share growth rate.

Because stocks are real assets, whose earnings reflect changes in inflation, it doesn’t make sense to compare them to bonds. Stocks’ nominal earnings shouldn’t grow much in a low interest rate/low inflation environment.

That means a low starting earnings yield combined with low inflation (and low nominal earnings per share growth) should produce subpar returns. According to Asness, you can believe in the Fed Model, or you can believe that stocks are real assets that reflect inflation — but you can’t believe both.

Additionally, it isn’t clear why investors should demand the same or a similar earnings yield from stocks as the interest yield on the 10-year Treasury. Before the 1960s, after all, investors demanded a higher current yield from stocks than from bonds in order to be compensated adequately for the risks of owning stocks. That’s also why junk bond investors today demand higher yields. Even the descriptive power of the Fed Model (that low bond yields encourage higher stock prices) is limited, because it only seems to work since 1965 or so.

Lieberman thinks investors are suffering from a fear hangover from the 2008-09 market meltdown, causing them to view stocks as overpriced. Maybe he’s right, but, as they say in psychiatry, even paranoids can have legitimate fears. It’s hard to see how a current Shiller PE of almost 30 and a dividend yield of 2% from stocks can produce robust future returns without Herculean earnings per share growth and/or yet another bump in multiple expansion. Moreover, anyone who writes an essay defending the Fed Model and higher-than-average stock prices should at least confront the evidence that Asness presents.

John
Coumarianos

John Coumarianos runs the website, Institutional Imperative, and focuses on value investing and behavioral finance. He formerly was a financial writer at mutual-fund company Capital Group and a mutual-fund and equity analyst at investment researcher Morningstar Inc.

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John
Coumarianos

John Coumarianos runs the website, Institutional Imperative, and focuses on value investing and behavioral finance. He formerly was a financial writer at mutual-fund company Capital Group and a mutual-fund and equity analyst at investment researcher Morningstar Inc.

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